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Schnitzer Steel: Not on the Scrap Heap

Small steel companies are speculative investments, but some have paid off big during the recent world industrial boom. Here is an obscure and unusual idea.

March 21, 2006

Selling scrap metal to China, a huge steel producer, sounds as foolish as carrying coals to Newcastle. But that, oddly enough, is one of the major attractions of Schnitzer Steel. The 100-year-old Oregon company is the largest U.S. exporter of scrap and is a "misunderstood China play" that, for the most part, is ignored by Wall Street, says Morgan Stanley analyst Wayne Atwell.

Morgan Stanley’s initiation came at virtually the same time that Goldman Sachs upgraded the stock to outperform. The Goldman move helped boost the shares 8% on Tuesday, to about $38. The stock (symbol SCHN) trades at ten times the average analyst earnings estimate of $3.82 per share for the fiscal year ending next August and nine times the $4.22 per share estimate for the August 2007 year. Stocks of most other U.S. mini-mill stocks, such as Nucor and Steel Dynamics, trade at double-digit price-earnings ratios.

Schnitzer is actually three businesses: steel recycling (its largest segment), mini-mill steel production and used auto-parts retailing, its smallest operation. The parts business looks like the odd duck, but it is profitable and steady, a counter to the cyclical steel business.

But it is, in fact, Schnitzer’s steel segments that make the stock interesting. The thinking is that over the next decade, the price of scrap, which is recycled into steel in mini-mills, will rise in lockstep with the key ingredients, such as coal and iron ore, used in traditional integrated steelmaking. As long as the global economy hums, Schnitzer’s profitability should improve. Morgan Stanley predicts that per-ton profit margins on scrap could expand by three to four times from the average margins of the past decade.

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Not counting Tuesday’s upgrade-inspired jump, Schnitzer stock hasn’t done much in a while. But that’s part of the appeal. When Schnitzer moves, it really moves -- the shares rose more than 500% in 2003, for example. It sure can’t hurt to have analysts from big securities firms suddenly sound the charge for an obscure company with a stock that’s worth barely more than $1 billion.

One caution: Schnitzer still needs to wrap up the settlement of an SEC investigation over questionable past payment practices in Asia. The company says this is old news, but it still has to refer to this matter in earnings statements and other disclosures.